Special Report

A few weeks ago, the gold price had a short-lived rally and then promptly collapsed again to its previous trading range. If you bear with me for a few minutes, I will show you why gold's failure to sustain its recent rally is confirmation that our model of the gold price is intact and that the potential rise in the price of gold, which we anticipate, could occur at any moment.

Around February 20th, gold lease rates started increasing, rising from the sub 1% level to reach as much as 6.3% on March 9th. Analysis of the lease rates showed that this was a short squeeze rally and as such, was unlikely to last very long, or go very far. One-month lease rates increased the most, rising from just over 1% to more than 6%. Two-month lease rates increased to over 4.5% and twelve-month lease rates increased to only 2.7%. From this it was clear that there existed a short-term demand for gold and not a long-term demand, a classic indication of a short squeeze.

Furthermore, this short squeeze coincided with a Bank of England gold auction and there were rumors in the market that gold loans, which were due around that time, would not be rolled over, which means that the borrower would have to come up with physical gold to repay the loan. While I cannot substantiate this rumor, it does not seem unreasonable because on the day of the gold auction, Tuesday March 13th, one-month lease rates declined by 24% and by the end of the week, the lease rate had declined by 62% from its high. It appears that whomever needed the gold, needed it badly and quickly. The gold was either bought at the auction to cover the short position, or one of the buyers at the auction made gold available as a loan to cover the short position.

It is important to note that the Bank of England auction dates are set long in advance, which means that the auction was not a response to rising gold prices and the prevailing short squeeze.

But the gold price quickly returned to its previous trading range in the low $260's. It was quite obvious that this would occur because during that time the US dollar was stable against foreign currencies, actually rising by 0.11%. "So what?" you might say.

Well, the point is that gold is quoted in US dollars and in spite of what many people would have us believe, gold is not a commodity. Gold is money, pure and simple. Because of this, gold responds to exchange rate changes just like other currencies such as dollars, yen, euros and pounds. The market for gold as money is so much larger than the industrial market for gold, that it completely overshadows it. In order to understand the gold price, we have to understand its relationship to the US dollar and its dependence on the US dollar exchange rate. (For more information on the relationship between gold and the dollar, please read, "Understanding the gold price and how to profit from it". You can get a complimentary copy by calling me at the office at 800-477-7853 (760-943-3939) or on the internet at www.pve.net)

That begs the question, where is the dollar heading? Surely with all that is going on the United States the dollar should have been dethroned by now and taken a tumble, so why is it so strong?

During the past eleven years, foreigners have invested approximately $1.7 trillion dollars in the United States. In fact, it is precisely because of this tremendous amount of foreign investment that the US economy got such a boost during the 1990's. Our economic miracle is the result of cheap foreign capital and not the genius of Greenspan, Clinton or any of the "new era" technologies that supposedly increased productivity, etc. etc. This influx of capital is also why the dollar has been so strong and since the US dollar gold price is just a reflection of the US dollar, it is also why the gold price has been so weak. A strong dollar has more buying power and hence as the dollar strengthened, it also strengthened against gold.

Foreigners poured their savings into the US because of financial and economic malaise around the world. The US economy was perceived to be stronger and growing faster than most other large countries and the financial risk in the US was perceived to be relatively low. But this was in essence a self-fulfilling prophecy; as money poured into the US, the US economy grew stronger and in part because US imports also surged to unprecedented levels, the strong dollar kept inflation under control. In return this stimulated more foreign investment that further fueled the US economy.

But now it seems as if the party is finally over. Us economic growth is slowing down, inflation is rearing its ugly head and the Federal Reserve is increasing the US money supply by more than 20% per year in order to fight off a recession. Layoffs are rampant and profits are disappearing like mist under the morning sun. US interest rates are falling and that means not only has the US economic miracle been discredited, US economic growth is now projected to be about half as much as Europe's while US interest rates are fast converging with Europe's. These are both extremely important issues.

In order for the US dollar to weaken, and hence the gold price to rise, money has to flow from the US to another destination. The question is where? Japan's banking woes are far from over and Japanese economic growth is still lacking. It is unlikely that much capital will move from the US to Japan until Japan's banking crisis is resolved and its economy shows signs of life. Strangely, while the capital trapped in the US is unlikely to flow to Japan, if it did, it would create another self-fulfilling prophecy since the capital influx would stimulate the Japanese economy and strengthen the yen. But the banking sector remains problematic.

That essentially leaves only Europe as an alternative investment destination. For a while it looked as if the euro had finally bottomed out and was poised to rise, giving the world an alternative to the US dollar. But the euro faltered and hence the dollar's strength was preserved, which is why the price of gold could not sustain the short rally of a few weeks ago.

The introduction of the euro may one day be perceived to have been the final folly of an era infatuated with fiat currencies. The euro is the ultimate fiat currency. As Doug Casey would say: "it is a floating abstraction". But nonetheless, the euro is the only real competition that the dollar has and until the European community, and particularly the European Central Bank, can convince investors that the euro is dependable, the dollar is bound to remain supreme.

Just like with Japan though, there is a bit of a chicken-and-egg situation. With the decline in the US economy and US interest rates, the US is no longer vastly more attractive than Europe. But that hasn't made European investments attractive enough. However, if some of the capital currently tied up in the United States was to move across the Atlantic, it would give the European economy a boost and increase the euro relative to the dollar. This almost happened at the end of last year when the euro rallied approximately 15% against the dollar.

But then European consumer confidence fell, the economy sputtered, inflation fears were rekindled and the euro rally lost momentum. Europe has long dreamed of an economic block able to compete with the United States and a currency able to compete with the dollar as a reserve currency. This is what the euro is supposed to be, but it hasn't passed muster yet. It is important to remember that in this environment of managed currencies, it is not always absolute value that is important, but relative value. Furthermore, because we are dealing with fiat currencies there is no intrinsic value, only perceived value; and perceptions can change overnight.

It is absolutely impossible to predict what could or would or will cause investors to change their relative perception of the dollar versus the euro, but I believe that whatever it is, it will happen sooner rather than later. In the US we have had nothing but good fortune and good news for almost two decades; the probability of bad news surprises outweigh the probability of good news surprises. In Europe almost exactly the opposite is true.

Furthermore, the outrageous US trade deficit and reliance on foreign capital is an overwhelming force that puts tremendous pressure on the dollar to decline. It is only because of all the economic and financial turmoil throughout the rest of the world that the US dollar has been able to remain so strong. With perhaps only a few exceptions, it now appears as if most of the bad news that the rest of the world has suffered from is behind us. Therefore it seems likely that the next major currency crisis will be that of the US dollar. The US dollar has to decrease in order to restore balance to the world's foreign trade flow and that is ultimately the dollar's Achilles' heel.

So in order for the gold price to sustain a rally in terms of US dollars, we will need to see the dollar weaken against foreign currencies. Overprinting gold's price movements will be the volatility introduced by speculators, large buyers and sellers but most importantly, the physical short position that has been exposed by the work of Frank Veneroso. If Veneroso is only partially correct, we could see a short squeeze of magnificent proportions develop in the gold market. In the mean time, there could be many smaller short squeezes that play havoc on the gold price and the emotions of gold investors. It is difficult not to get excited about a gold price rally when you are long up to your eyeballs in gold related investments, but until we see the dollar decline, I am afraid that any gold price rally will be short lived. On the other hand, I believe a decline in the dollar is not only unavoidable, it could happen any day now.

Paul van Eeden
Paul van Eeden is a widely respected financial analyst who has written extensively about the relationship between the U.S. dollar and the price of gold. For more information, please visit Paul's website at: http://www.pve.net/.